Weighted Average Cost of Capital and Midland Energy

Executive Summary: Midland Energy Resources, Inc. is a global energy company with a broad array of products and services. The company operates within three different operations including oil and gas exploration and production (E&P), refining and marketing (R&M), and petrochemicals. Midland has proven to be a very profitable company, with reported operating revenue of $248.5 billion and operating income of $42.2 billion. The company has been in business for over 120 years and employed more than 80,000 individuals. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, has been asked to calculate the weighted average cost of capital (WACC) for the company as a whole, as well as each of its three divisions as part of an annual budgeting process. Midland’s Three Divisions: Exploration & Production Oil exploration and production (E&P) is Midland’s most profitable business, and its net margin over the previous five years was among the highest in the industry. With oil prices at historic highs in early 2007, Midland anticipated heavy investment in acquisitions of promising properties, in development of its proved undeveloped reserves, and in expanding production. They also needed to account for competition from areas such as the Middle East, Central Asia, Russia, and West Africa. Refining and Marketing Midland had ownership interests in forty refineries around the world with distillation capacity of five million barrels a day. Measured by revenue, this side of the business was Midland’s largest. The relatively small margin was consistent with a long-term trend in the industry. Margins had declined steadily over the previous twenty years. Petrochemicals Petrochemicals is Midland’s smallest but most promising and undervalued division. Midland owned twenty-five manufacturing facilities and five research centers in eight countries around the world. Capital spending in petrochemicals was expected to grow in the near term.

[Midland Energy Case Analysis] Managerial Finance

1

In order to find the cost of capital for Midland Energy Resources and each of the three divisions within the company, we will need to use the formula for weighted average cost of capital (WACC) which is: ( )( rd= Cost of debt re= Cost of equity D= Market value of debt E= Market value of equity V= D+E= Value of the company (or division) T= Tax rate First, we can calculate “rd” for each division as it is outlined in the case by adding a premium/spread over US Treasury securities of a similar maturity. In other words: ( The two tables in the case are as follows: Table 1 Business Segment Consolidated E&P R&M Petrochemicals Credit Rating A+ A+ BBB AATable 2 Maturity 1-Year 10-Year 30-Year Rate 4.54% 4.66% 4.98% Debt/Value 42.2% 46.0% 31.0% 40.0% Spread to Treasury 1.62% 1.60% 1.80% 1.35% ) ) ( )

*For my calculation, I used the 30-year maturity for E&P, R&M, and Midland as a whole as they take on longer term projects. I used the 1-year for petrochemicals as they tend to take on short term projects.

[Midland Energy Case Analysis] Managerial Finance

2

Calculations are as follows: rd for Exploration & Production:

rd for Refining & Marketing:

rd for Petrochemicals:

rd for Midland:

Second, we need to calculate “re” for the three divisions as well as Midland as a whole. To find “re”, we will use the CAPM model outlined in the case: ( )

In order to solve this equation, we need to find beta for the three divisions. The case already outlines Midland’s overall beta at 1.25. However, the case does not state the beta for the three divisions. We can calculate this using beta for publicly traded companied outlined in the case. Using the following formula, as well as exhibit 5 in the case, we can calculate beta for the three divisions:

You May Also Find These Documents Helpful

...countries with a range of products on sales in over 170 countries. These products are sold everywhere convenience stores, grocery stores and kiosks.
2 - Cost of Capital
A company’s capital is consists of mostly debt or equity. Equity and debt are external sources of financing and financing from external sources is not without cost. The cost of capital is the cost to raise capital through equity and debt. It can be defined as the weighted sum of the cots of equity and the cost of debt. It determines the rate of return that a firm would receive if it invested its money in another option with a similar risk. A risky business will have a higher cost of capital than one involving less risk as the investors expect to be compensated for the greater risk.
It is easy to determine the cost of debt. Cost of debt is simply the weighted rates of interest paid by the company on its debts. However, cost is equity is not so straightforward. The cost of equity is based on an estimate of a reasonable rate of return on the shareholders' investment. The term ‘reasonable’ is what makes all the difference. There are various models which are used to estimate this reasonable rate of return which will satisfy the shareholders. One such model is...

...WeightedAverageCost of Capital
What It Measures
The weightedaveragecost of capital (WACC) is the rate of return that the providers of a company’s capital require, weighted according to the proportion each element bears to the total pool of capital.
Why It Is Important
WACC is one of the most important figures in assessing a company’s financial health, both for internal use (in capital budgeting) and external use (valuing companies on investment markets). It gives companies an insight into the cost of their financing, can be used as a hurdle rate for investment decisions, and acts as a measure to be minimized to find the best possible capital structure for the company. WACC is a rough guide to the rate of interest per monetary unit of capital. As such, it can be used to provide a discount rate for cash flows with similar risk to that of the overall business.
How It Works in Practice
To calculate the weightedaveragecost of capital, companies must multiply the cost of each element of capital for a project—which may include loans, bonds, equity, and preferred stock—by its percentage of the total capital, and then add them together.
For example, a business might...

... The projects which increase shareholder value can result in profitable and competitive advantage.
The third financial strategy of optimizing the use of debt in the capital structure helps the company to maximize the revenues from its debt’s management. Marriott invests a large sum of money in long-term asset. It is essential to maximize and optimize its long-term debt to meet the need of investment. Generally, Marriott optimize the use of debt in its capital structure helps the company maximize revenues from its debt’s management.
The fourth financial strategy of repurchasing undervalued shares is also accordance with the growth objectives. Marriott calculates a “warranted equity value” and will repurchase its stocks if the price falls below the “warranted equity value”. By selling its undervalued common shares, Marriott is able to increase the profits. Also, the company uses the measure of warranted value instead of day-to-day market price of its stock. It allows Marriott not to depend on the market price.
Q2-5:
Marriott measured the opportunity cost of capital for investments of similar risk using the weightedaveragecost of capital (WACC). It is an appropriate method to use for calculating cash flows with risk that leads to estimate the risk of investment projects. Meanwhile, the cost of capital will be calculated for...

...WACC WeightedAverageCost of Capital Formula
The WACC WeightedAverageCost of Capital formula is complex, and can be broken into several components. The individual component costs are provided in the following sections.
WACC WeightedAverageCost of Capital Variables
V=Firm Total Value (Debt + Preferred Shares + Common Equity + Retained Earnings)
Md=Market Value of Debt
Mp=Market Value of Preferred Shares
Mc=Market Value of Common Equity
Mr=Market Value of Retained Earnings
K=Current Market Interest Rate
T=Tax Rate
Dp=Annual Dividends for Preferred Shares
Pp=Market Price of Preferred Shares
Fp=Floatation Costs of Preferred Shares
Dc=Annual Dividends for Common Shares
Pc=Market Price of Common Shares
Fc=Floatation Costs of Common Shares
G=Constant Growth Rate of Common Share Dividends
Cost of Debt Formula
Cost of Debt is the cost to the company for the use of borrowed funds to finance operations.
K=Current Market Interest Rate
T=Tax Rate
Cost of debt = k(1-T)
Cost of Preferred Shares Formula
Cost of Preferred Shares is the cost to the company for the use of funds generated by selling preferred shares to investors.
D=Annual...

...Introduction:
MidlandEnergy Resources, Inc. is a global energy company with its operations in three divisions – Oil and gas exploration, Refining and Marketing and Petrochemicals. The company has been there for 120 years and in 2007 had more than 80,000 employees. It has been a very profitable company with reported operating revenue of $248.5 billion and operating income of $42.2 billion in 2006. The primary goals of Midland’s financial strategy are to fund overseas growth, invest in value-creating project, achieve an optimal capital strategy and repurchase undervalued shares. To accomplish all these goals the company has asked Janet Mortensen, Vice President of finance for Midlandenergy resources, to calculate the weightedaveragecost of capital (WACC) for the company as a whole.
Formula: WACC = rd (D/V) (1-t) + re (E/V)
Where, rd = cost of debt; re= cost of equity; D = Market value of debt; E= Market value of equity; V= Market Value of the company (D+E); t= Tax rate.
Risk Free Rate, rf: Midland’s borrowing capacity is typically depended on its energy reserves and long-term assets. Considering its assets long-term valuation a 1-year risk free rate seemed unreasonable. Furthermore there is a high correlation of Midland’s stock price with changes in energy prices, which...

...WACC:
Weightedaveragecost of capital =WACC= SS+B×Rs+BS+B×RB×1-tC
note: Rs , cost of equity; RB , cost of debt; tC , corporate tax rate.
For cost of equity, Rs, we calculate it by using the SML, according to CAPM model.
Rs=RF+β×[RM-RF]
As we can see in the chart behind the case, beta of Worldwide Paper Company is 1.10; the Market risk premium (RM-RF) is 6.0%. Because this on-site longwood woodyard project has six year life and the investment spend over two years, the total long of this program is more closer to 10-years, we choose the 10-year government bonds as risk free rate, 4.60%.
Thus, Rs=4.60%+1.10×6.0% =11.20%.
For the cost of debt, there are two kinds of debts of Worldwide Paper Company, bank loan and long-term debt.
The cost of long-term debt is 5.78% (A rating 10-years maturities corporate bonds) , and the value of long term debt is $2500M.
Thus, RB=5.78%.
For the value of equity and debt, market value weights are more appropriate than book value weights, because the market values of the securities are closer to the actual dollars that would be received from their sale. There are the market weights expected to prevail over the life of the firm or the project.
S=500×$24.00=$12,000M; B=$2500
RWACC=1200012000+3000×11.20%+300012000+3000×5.88%=9.76%
Payback Period:
YEAR | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 |...

...channels, Yeats has a stronger national and direct distribution channel. TSE has a larger mass market production system (high volume) while Yeats has a more customized market production (lower volume). In addition, Yeats has a strong R&D, having many patents for multiple applications, particularly with its latest development of the Widening Gyre Program that has a high-profile government contract. This might not be reflected in the stock of the company as a growth opportunity.
3. Why should Yeats and TSE want to negotiate a merger deal?
Yeats is considering this merger deal because it would offer a succession plan for the company as TSE is a much larger company that can offer Yeats financial stability without having Yeats to identify new capital (debt and equity) on its own to fund the Widening Gyre Program (an advanced hydraulic-controls system). Yeats needs additional funding in order to continue the R&D of the Widening Gyre Program. Also, TSE has the expertise of mass manufacturing that Yeats need for widening its reach in commercialized distribution. In order to maintain a competitive edge, Yeats need both the finance and manufacturing capabilities of TSE as other competitors in the same industry have been consolidating more and more.
However, Bill Yeats is concerned about losing voting control from a merger with TSE. He also wants to ensure that Yeats employees are kept after the merger and its stockholders gain value from the merger. He...

...estimate the WeightedAverageCost of Capital (WACC) for both its Telecommunications segment and its Products and Systems segment and then compare that to the firms corporate WACC. The WACC assesses the amount the risk that an averagecapital project undertaken by the firm contains. It is also the required rate of return the firm must end up paying in order to later generate funds, which can then be used as a benchmark to determine how profitable an investment is or may be.
In order to begin calculating WACC we first must calculate the cost of equity for each segment. By comparing Teletech to that of other publically traded companies in the same industry we determined that a beta of 1.04 was appropriate for the Telecommunications segment, and a beta or 1.36 for the Products and Systems segment. Using the CAPM approach, we took the segments betas as well as our calculated market risk premium of 5.5% (See section 1 of Calculations) and were able to determine the cost of equity for the Telecommunications segment to be 10.34% and the Products and Systems segment to be 12.1%.
Continuing further we applied each segments after-tax cost of debt along with the firm's percentage weights of debt and equity, 22.2% and 77.8% respectively and were able to determine that the Telecommunications segment had a WACC of 8.8% while the Products and Systems segment had...